Monthly Archive November 2015

Role of price mechanism

Role of price mechanism in full utilization of productive resources in free enterprise economy

  1. Explain the role of “Price mechanism” in assuring proper allocation and full utilization of productive resources in free enterprise economy.

Ans) Price mechanism refers to the process of price determination by the interaction between demand and supply forces without any external interference. That price will come to prevail in the market at which demand for a commodity is equal to its supply. Such a price is called equilibrium price. Operation of price mechanism in a market is explained with the help of the following figure. In this figure, price  per unit of the commodity is shown on Y-Axis and quantity demanded and supplied are shown on X-axis.

At OP1 price ,supply (P1B) is more than demand (P1A), ie; there is AB excess supply .In this situation there will be a tendency for the price to fall ,as there will arise competition among the sellers.

On the contrary, at OP2 price, demand (P2G) will be more than supply (P2F) ie; there will be excess demand equal to FG. In this situation, there will be a tendency for the price to rise ,as it will lead to competition among the buyers.

At OP price, demand is equal to supply. Thus, OP price is called equilibrium price. At this price, demand for a commodity is equal to its supply.

Role of price mechanism:

The price mechanism solves the problem of allocation of resources which is associated with what ,how and for whom to produce.

  • What to produce?

         In a free market economy,producers are guided by profit motive. When price of a commodity increases with the increase in demand ,the profits  increase and this would encourage the production of this commodity.Producers would shift resources from the production of other commodities to this commodity.Therefore,the price mechanism would automatically solve the problem what to produce.

  • How to produce?

          It is the question of choice of production technique .There are generally two techniques of production available:

  1. Labour-intensive technique (in which more of labour is used than capital)
  2. Capital-intensive technique (in which more of capital is used than labour)

      If capital is available at alower rate, firms adopt capital-intensive technique of production.If labour is available at lower rate,firms adopt labour intensive techniques.

Therefore, it is the price of labour or the price of capital that will help the producer in deciding whether they should choose capital intensive or labour intensive technique.

  • For whom to produce?

       In a market economy,the producers must produce for those who have the ability and willingness to pay the highest price.The income of the consumers determines the ability to pay ie; there is a direct relationship between income and consumption pattern. Hence,both the ability and willingness to pay determines who gets the available commodities.

  • Fuller Utilization of the factors

         It is through price-mechanism that fuller utilization of the factors is attained in a capitalist economy .Volume of full employment depends upon the volume of production which in its turn ,depends upon the level of investment. Amount of investment  depends upon saving.Equality between saving and investment is brought about by change in price of capital ie; rate of interest.If at any given time ,total savings are large and condition of unemployment prevails in the economy ,the rate of interest will fall.Due to fall in the rate of interest there will be increase in investment.Increase in investment will result into increase in production and the condition of less than fuller utilization of the factors will become possible. Classical economists were of the view that under condition of less than full employment of labour,price of labour, ie; wage will fall. Fall in wage rate will stimulate demand and condition of full employment of labour will be achieved . In this way,price mechanism will help to achieve fuller utilization of the factors.


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Microeconomics- Business Decision making

Microeconomics- Business Decision making

  • a)Explain the role of microeconomics in business decision making.

Ans) The role of microeconomics in business decision making can be explained as under:

1) Optimal resource utilization:

The productive resources are scarce in the economy and microeconomics tells how the productive resources are allocated in the production of various goods and services .It also helps to find out ,what to produce, how much to produce and for whom to produce.

2) Demand analysis:

With the help of microeconomic analysis ,the business firms try to forecast the demand for their product. As we know ,the demand for the firm’s product would change in response to change in price of the firm’s product ,prices of other goods ,which may be substitute or complementary,consumer’s income ,his testes and fashion ,his expectations about future changes in price ,changes in the age composition  of population ,change in total population etc. These are the determinants of demand ,a study of which is essential for forecasting future demand for the product as well as the present sales.

3) Cost analysis:

Cost analysis is an important area of microeconomics .There are many theories to explain different condition of cost in microeconomics such as fixed cost and variable cost,average cost and marginal cost,short-run cost and long-run cost. These all help the business manager to compare cost of production of different periods and thereby to evolve suitable policies in controlling costs and deriving suitable profits.

4) Optimal production decision:

The production decision is concerned with proper product mix.What factors are to be combined in what manner to produce a given product ? Microeconomics deals with different production techniques that help to find out the optimal production decision.

5) Pricing policy:

We know that pricing of the product is the chief function of a firm. This depends upon the cost of production and at the same time price of substitutes and the nature of competition. Price affects profits which in turn determine the existence and the growth of the firm.The microeconomic analysis provides the business manager a thorough knowledge of the theories of production and pricing in order to make sure that the firm gets profits continuously.

Thus ,the role of microeconomics is both positive and normative .It not only tells us how the economy operates but also how it should be operated to promote general welfare.


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